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CHAPTER 8

DERIVATIVES
MARKET

Objectives

Definition and purpose of derivatives


market
Derivative instruments
Exchange-traded versus over thecounter derivatives
Market players and institutions

Introduction
by far the most significant event in finance
during the past two decades has been the
extraordinary development and expansion of
financial derivatives.
These instruments
enhance the ability to differentiate risk and
allocate it to those investors most able and
willing to take it a process that has
undoubtedly improved national productivity
growth and standards of living.
(Alan Greenspan)

Introduction

Transactions in the market:


Spot transactions
Delivery happens on the spot
Forward transactions
Delivery happens sometimes in the future but

the price and quantities are determined today

Introduction
Derivatives are instruments created to
minimize risk
Their value are derived from something

From an asset
Example: share prices, prices of commodity,

indices and interest rates


Commodity derivative if the underlying assets are
commodities such as palm oil, coffee, wheat etc.
Financial derivative if the underlying assets are
financial assets such as debt instruments,
currency, share price etc.
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Introduction

Definition:
Derivative instruments are simply financial

instruments which have values determined


by prices of the underlying assets
Their values depend on prices of underlying
assets

3 main derivative instruments:


Futures
Forwards
Options
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Need for Derivatives


The derivatives market performs a number
of economic functions. They help in :
Transferring risks
Discovery of future as well as current
prices
Catalyzing entrepreneurial activity
Increasing saving and investments in
long run.

Participants in Derivative
markets

Hedgers use futures or options markets to


reduce or eliminate the risk associated with price
of an asset.

Speculators use futures and options contracts to


get extra leverage in betting on future movements
in the price of an asset.

Arbitrageurs are in business to take advantage


of a discrepancy between prices in two different
markets.
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Question

How can prices contain risk element?


What is the main function of derivative
instruments? How?

History of Derivatives

Started as early as 1848 in the US


Mainly concentrated in the commodity market
1919 the establishment of Chicago Mercantile Exchange

(CME), providing futures contract on various commodities


Later, New York Mercantile Exchange and Chicago Board
Options Exchange were developed
Financial derivatives began to dominate trading during the 1970s
In the early 1980s, most of the financial futures were traded in
US
But later, in the mid1980s to 2003, new exchanges were
developed throughout Europe, South America and Asia Pacific
region

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History of Derivatives

The main reason for the change was


because of the significant increase in
net private capital inflows from the
developed markets to the emerging
markets
The link between the development of
derivatives market and price variability
of financial instruments is natural risk
management if there is risk
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The Development of Malaysian


Derivatives Market
From 1980 1995, our derivatives market was confined
mainly on the crude palm oil (CPO) futures traded on the
Kuala Lumpur Commodity Exchange (KLCE)
In 1995 Kuala Lumpur Options and Financial Futures
Exchange (KLOFFE), now known as Bursa Malaysia
Derivatives Berhad (BMD) which is 75% owned subsidiary
of Bursa Malaysia Berhad. 25% owned by CME. It
provides, operates and maintains a futures and options
exchange.
BMD operates the most liquid and successful crude palm
oil futures contract in the world
On 15 Dec 1995, the first financial futures contract based
on the KLSE CI was traded on KLOFFE

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The Development of Malaysian


Derivatives Market

May 1996 Malaysia Monetary Exchange (MME)


was set up to provide fixed income derivatives,
namely 3-month KLIBOR futures contract
In 1998 KLCE + MME = COMMEX (Commodity
and Monetary Exchange of Malaysia)
Jan 1999 KLOFFE became the subsidiary of
KLSE
June 2001 KLOFFE + COMMEX = Malaysian
Derivatives Exchange (MDEX)
MDEX was renamed Bursa Malaysia Derivatives
Berhad on 20 April 2004
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The Development of Malaysian


Derivatives Market

BMD operates under the supervision of


SC and is governed by the Capital
Market and Services Act 2007
On September 17, 2009, BMD entered
into a strategic partnership with Chicago
Mercantile Exchange

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Derivative Products Traded on


BMD

Products (http://www.klse.com.my/website/bm/derivatives/products/)

BMD has the following products available to be traded on the CME Globex electronic trading
platform

Commodity Derivatives
Crude Palm Oil Futures (FCPO)
USD Crude Palm Oil Futures (FUPO)
Crude Palm Kernel Oil Futures (FPKO)
Equity Derivatives
FTSE Bursa Malaysia KLCI Futures (FKLI)
FTSE Bursa Malaysia KLCI Options (OKLI)
Single Stock Futures (SSFs)
Financial Derivatives
3 Month Kuala Lumpur Interbank Offered Rate Futures (FKB3)
3-Year Malaysian Government Securities Futures (FMG3)
5-Year Malaysian Government Securities Futures (FMG5)

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Questions

In what way derivative instruments can


be used to minimize the risk of financial
instruments such as equity?

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Basic Terminologies

Spot Contract: An agreement to buy or sell an asset


today.
Spot Price: The price at which the asset changes
hands on the spot date.
Spot date: The normal settlement day for a transaction
done today.
Long position: The party agreeing to buy the
underlying asset in the future assumes a long position.
Short position: The party agreeing to sell the asset in
the future assumes a short position
Delivery Price: The price agreed upon at the time the
contract is entered into.
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Forward and Futures Contracts

Forward Contract
A contract between two parties agreeing to carry

out a transaction at a future date but a price


determined today
Steps involved in buying crude palm oil:
1. Setting the price to be paid, exact specification

of quality, quantity and delivery logistics, such as


time, date and place
2. Delivering the crude palm oil from seller to buyer
3. Payment of cash from buyer to seller
How does the forward contract work?
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Forward and Futures Contracts

Time to settle the contract in the future


expiration date
Example: a rice farmer
How long does it take to harvest the paddy?
Price risk
What is the price risk for the farmer?
What is the price risk for the producer?
Since both are facing the price risk, a forward contract

can help them eliminating the price risk. How?


A seller short position
A buyer long position

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For Example:

If A has to buy a share 6 months from


now. and B has to sell a share worth
Rs.100. So they both agree to enter in a
forward contract of Rs. 104. A is at
Long Position and B is at Short
Position Suppose after 6 months the
price of share is Rs.110. so, A overall
gained Rs. 4 but lost Rs. 6 while B
made an overall profit of Rs. 6
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Forward and Futures Contracts

Futures Contract
To overcome 3 problems of forward contracts:
1. Multiple coincidence needs

Match the underlying asset, delivery date or maturity


and specified quantity

2. Unfair forward price


The party who has better negotiating power may
dictate unfair price
3. Counterparty risk
One party may default which create losses to the
other party

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Forward and Futures Contracts

Futures contract
An exchange-traded form of forward contract
A commitment to buy or sell an underlying asset at a future

date
Contracts are standardized
Except for price - quantity, quality of the underlying asset,

deliver date and location of delivery


Traded electronically
The price is determined based on the interaction between

many buyers and sellers


The counterparty risk is reduced through a clearing house
Guarantees the performance of the parties in each transaction

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Hedging, Speculating and


Arbitraging with Futures
Contracts

Hedging with Futures

The profitability of most individuals and

corporations is affected by the changing prices


of commodities and financial instruments
Risk of price fluctuations (price risk)

Futures markets provide a means of cancelling

out the exposure to drastic price fluctuations in


the underlying or physical market
The purpose of hedging to preserve the
wealth

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Hedging, Speculating and


Arbitraging with Futures
Contracts

Hedging

1. Taking a future position in anticipation of a

later cash transaction (anticipatory hedging) or

Example: the palm oil producer who intends to


sell his palm oil in two months could lock in the
price by selling the futures contract today
If the future price of the palm oil decreases, .
The basic idea of hedging is to establish an
opposite position in futures so that the gain from
the futures position cancels out the loss from the
underlying or physical market position

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Hedging, Speculating and


Arbitraging with Futures
Contracts

2. Taking a future position opposite to the

current physical position held (hedging the


current market position)

Example: a fund manager with a portfolio of


shares could hedge against a fall in share
prices by selling stock index futures contract
today
When the fund manager locks in the price, if
the future price of the index drops, the decline
or loss in portfolio value is compensated by
the gain from the futures position

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Hedging, Speculating and


Arbitraging with Futures
Contracts

How do we determine when we should


buy (long) or sell (short) a futures
contract?
2 ways:
1. To observe the hedge from the underlying
position
2. To observe from the point of price risk. To
protect from the rising prices, the trader
should buy the futures contract. To protect
against falling prices, the trader should sell the
futures contract.
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Hedging, Speculating and


Arbitraging with Futures
Contracts

Advantages of trading futures contracts:


The minimum margin requirements allow

traders to leverage their investments, that is,


to trade many times more than the original
cost of investment
A futures contract does not have to be held
till it expires or matures. It can be closed out
before the contract expires by making an
opposite transaction
Low transaction costs
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Hedging, Speculating and


Arbitraging with Futures
Contracts

Disadvantages of trading futures


contract:
The futures contracts are standardized
May prevent the hedger from benefiting from

favorable price movements

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Hedging, Speculating and


Arbitraging with Futures
Contracts

Speculating with Futures

Deal with price changes that occur in the

market
Try to make profit. Example: buy futures at a
low price, then sell it at a high price
An important role: provide the depth and
volume of trading that allows hedgers and
others to enter or exit the market easily
Provide liquidity and continuous trading

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Hedging, Speculating and


Arbitraging with Futures
Contracts

Speculating with Futures


3 types of trades
1. Scalpers

Look out for minimum price fluctuations on large

volumes taking small profits at a time

2. Day traders
Do intraday trading and on small volumes of trade
3. Position traders
Look for long-term price trends and may hold on
their position over weeks, or months

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Hedging, Speculating and


Arbitraging with Futures
Contracts

Arbitraging with Futures

Arbitrage in the practice of taking advantage of price

differentials across different markets


Simultaneous purchase and sale of the same instrument

in different markets to profit from the temporary price


differences
Example: currency trading
Arbitrageurs also play an important role in providing

liquidity and by ensuring the price of cash and futures


converges at the expiry date of the contract

Chapter 7 ends up to here (you can read the


rest for your own understanding)
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Options derivatives

It is a contract between a buyer (option


buyer) and seller (option seller) in which
the buyer of the option has the right but
not the obligation, to buy or sell a certain
asset at a certain price before a certain
date.
What is the difference between the
right and obligation?

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Some Terminologies

Call Option: Right but not the obligation to buy


Put Option: Right but not the obligation to sell
Option Price: The amount per share that an option
buyer pays to the seller
Expiration Date: The day on which an option is no
longer valid
Strike Price: The reference price at which the
underlying may be traded
Long Position: Buyer of an option assumes long
position
Short Position: Seller of an option assumes short
position
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Options derivatives

Selling an option (writing an option)


versus buying an option (take)
The option seller is obligated to perform
according to the terms of the contract
once the option buyer exercises the
option

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Options derivatives

Difference between options and futures


Right versus obligation
Risk of loss is carried by the option seller
The option buyer is protected from
unfavorable market movements
Fulfillment of the contract
Futures both parties are obliged to transact

at the same specified time in the future


option only one party is obliged to transact,
when the buyer exercising the option.

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Options derivatives

Advantages of options:
Limited risk (applicable to buyers only)
Option sellers have unlimited risk similar to
future holders
Flexibility
Standard options provide flexibility to trade

freely in the open market


Improves liquidity and allowing prices to be
more accurately priced

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Options derivatives

Exchange-traded options
Originate and traded on a formal exchange
Most commonly are equity options
Traded using electronic trading systems
Settled through a clearing house (MDCH)
Novation
A process whereby it connects the two contracting parties

Standardized except for the price

Over-the-counter options
Not traded through a formal exchange
Arrange deals through telephone or on face-to-face meetings
Able to negotiate as to quantity, quality maturity and delivery
Higher credit risk

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Classification of
Derivatives

Future Contracts
Forward Contracts
Options
Swaps

OTC (Over the


counter ) trading
Exchange Traded
Derivatives

OTC

Exchange Traded

RM Interest Rate
Derivatives

Forward Rate
agreements, Interest
rate Swaps

Interest Rate futures

Foreign Currency
Derivatives

Forwards, Swaps,
Options

Currency Futures

Equity Derivatives

Index Futures, Index

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Uses of Options
1.

Investment in options provides leverage


Purchase of option requires only payment of the premium

which is usually a small percentage of the price of the


underlying asset
What about investment in shares?
2.

Options can be used extensively in risk


management
Hedging
The use of call and put options in the situation of rising and
falling prices

3.

To enhance portfolio returns


Having some shares may allow an investor to sell call

options to others to earn premium


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Uses of Options
4.

Options are very flexible financial


instruments
Can be used to create strategies to take

advantage of different situations


5.

Options are used to manage information


asymmetry
A situation where both parties to the

transaction do not have equal access to


market information
Attach put options with IPO
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Examples of options traded on


exchanges

Kuala Lumpur Composite Index Options


(OKLI)
SGX MSCI Singapore (SiMSCI) Options
SGX Nikkei 225 Index Options
SGX Eurodollar Options
KOSPI 200 Option
US Dollar Option
Hang Seng Index Options
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The Key Elements of an Option

Types of Options
Call Option
A call option gives the option buyer the right (but not the
obligation) to buy a specified asset at a specified price at
or before a specified date.
When the option buyer exercises the right, the option
seller is obliged to sell the asset to the option buyer.
Put Option
A put option gives the option buyer the right (but not the

obligation) to sell a specified asset at a specified price at


or before a specified date.
When the option buyer exercises the right, the option
seller is obliged to buy the asset from the option buyer.

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The Key Elements of an Option

Underlying assets
Shares, an index, a particular futures

contract, currencies, gold etc.


An index represents what?

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The Key Elements of an Option

Strike price or exercise price


It is an agreed price at which the underlying asset

is transacted if the option is exercised


The buyer will only exercise the option when
circumstances favour it
If the strike price is more favourable than the

prevailing price, such an option is described as inthe-money


So, when does a call option is described as in-themoney?
When does a put option is described as in-themoney?
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The Key Elements of an Option

An option is said to be at-the-money if the


exercise price equals the spot price of the
underlying asset
If this kind option is exercised, zero profit on exercise

and loss on the price paid for the option (premium)

An option price is said to be out-of-money is the


exercise price is higher than the price of the call
options underlying asset
What about a put option? When does it considered

as out-of-money?
For out-of-money, the option will not be exercised.

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The Key Elements of an Option

Expiry date and option style


Expiry date is the maturity date

Two types of option styles


American style option
Can be exercised at any time
European style option
Can be exercised only on the specified expiry

date

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The Key Elements of an Option

Premium
Cost or the price of an option
The price that the option buyer pays to the
option seller
Premiums are quoted as index points to one
decimal place
Example: 1 point for RM100, 0.1 for RM10. If the

premium is 25 points, then the price of the option is


RM2,500.

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The Key Elements of an Option

Premium is quoted based on the sum of intrinsic


value and time value
Intrinsic value is the profit that can be obtained on an

immediate exercise
Intrinsic value equals the amount where option is in-the-money
The option of at-the-money and out-of-money has zero

intrinsic value
Call intrinsic value and put intrinsic value?
Time value refers to the value that arises from the

probability that an option will become profitable before its


expiry date
As the option approaches expiry, time value reduces and

becomes zero at expiry

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Potential Gains or Losses on a Call Option:


Exercise Price = $115, Premium = $4

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Potential Gains or Losses on a Put


Option: Exercise Price = $110,
Premium = $2

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Swaps

Swaps are customized bilateral


transactions in which the parties agree
to exchange cash flows at fixed periodic
intervals, based on the underlying asset.
Over-the-counter instrument
Can be 1 month, 3 months, 6 months etc
Each side of swap is called a leg
Interest rate swaps

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Swaps

Example:
Let say Fair Ltd borrows RM50 million at a floating

interest rate of KLIBOR plus a credit spread of


0.5% payable in 5 years. Meanwhile, Adil Ltd
borrows RM50 million at a fixed interest rate of 9%
payable also in 5 years.
Fair Ltd and Adil Ltd may agree to swap their
liabilities whereby Fair will pay Adil a fixed interest
of 9% and Adil will pay Fair a floating rate of
KLIBOR plus 0.5%.
Companies involved in the swap agreements are
known as counterparties.
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Swaps
Illustration of an Interest Rate Swap to
Reconfigure Bond Payments

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Swaps

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Differences between Spot, Forward


and Futures Contract

Spot
0

3 months

price agreed/paid between + bonds deliver by seller to


buyer and seller
buyer

Forward

price agreed/paid between


buyer and seller

Futures
0

3 month
buyer pays forward
price, seller delivered bonds

Buyer and seller enter futures contract


At time t=0, futures price

month

buyer pays the futures price


quoted at the end of month 3

Seller delivered bonds


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